In this part, the Part 4 of my article on LBO, I’m going to run you through its economics – the metrics used to judge an LBO candidate and how it generates returns. But before reading further, you may want to take a glimpse of my previous articles on LBO through the following links so that we’re on the same page.
Part1: Leveraged Buyout – An Overview
Part2: Leveraged Buyout – What Makes a Strong LBO Candidate?
Part3: Leveraged Buyout – Key Participants
Metrics Used To Judge An LBO Candidate
There are two metrics that defines the attractiveness of an LBO candidate – (1) Internal Rate of Return (IRR), and (2) Cash Returns.
IRR is the primary metric that measures the total return on the sponsor’s equity investment (which includes additional capital infused or dividends received) during the investment period. For everybody’s benefit, an IRR is the discount rate at which NPV of all the cash flows (inflow and outflow) becomes zero.
The drivers that affect IRR are:
- target’s financial performance
- acquisition price
- financing structure, especially the equity contribution made
- exit multiple, and
- holding period.
As mentioned in my first article – LBO: An Overview -, a sponsor seeks a minimum of 20% return on their investment over their holding period of five years. So, it’s obvious (looking at the drivers of IRR) that minimizing the equity contribution and acquisition price, while exiting at a higher valuation by boosting the financial performance of the target, fetches handsome returns.
In case of cash return analysis, the sponsor looks at the return as a multiple of his cash equity investment. However, one important point to keep in mind here is that cash return approach does not take into account the time value of money.
Example
In the following illustration, the sponsor contributes $300 million of equity (cash outflow) to the purchase price in Year0 as part of the financing structure and realizes $850 million of cash inflow at the end of Year5, thereby gaining an IRR of 23.2% and cash return of 2.83x (assuming no additional equity investment or dividend received during the holding period).
Equity Investment
(Year 0)
Equity /Dividend
(Year 1)
Equity /Dividend
(Year 2)
Equity /Dividend
(Year 3)
Equity /Dividend
(Year 4)
Equity Proceeds
(Year 5)
($ 300 M)
0
0
0
0
$ 850 M
By definition, IRR is:
($300M) + [0 / (1+23.2%)] + [0 / (1+23.2%)] + [0 / (1+23.2%)] + [0 / (1+23.2%)] + [$850M / (1+23.2%)] = 0
How Does An LBO Generate Returns?
An LBO generates returns through a combination of (i) debt repayment and (ii) growth in enterprise value.
To understand the concept, let’s take the scenarios independently. Let’s say the sponsor acquires a target for $1.0 billion with $300 million of cash equity (30% of the acquisition price) and $700 million of debt financing (70% of the acquisition price).
Scenario I: Debt repayment (but NO increase in EV)
Scenario I: Debt Repayment (NO increase in EV)
Assumptions
Acquisition Price
$ 1.0 Billion
Equity Contribution
$ 300 Million
Investment Horizon
5 Years
Sales Price
$ 1.0 Billion
Debt Repayment
$ 550 Million
In this case, let’s assume that the target, during the investment horizon, generates a cumulative free cash flow of $550 million, which is used for debt repayment. As the debt is repaid over the holding period, equity value keeps on growing on a dollar-for-dollar basis. At the end of 5 years, when the sponsor sells the target for $1.0 billion (same price as the purchase price), the equity value of the sponsor increases from $300 million to $850 million (= $300 million + $550 million) despite no increment in the enterprise value. This generates an IRR of 23.2% and a cash return of 2.83x for the sponsor.
Scenario II: EV increases (but NO debt repayment)
Scenario I: EV Increases (NO debt repayment)
Assumptions
Acquisition Price
$ 1.0 Billion
Equity Contribution
$ 300 Million
Investment Horizon
5 Years
Sales Price
$ 1.55 Billion
Debt Repayment
$ 0
In this case, let’s assume the sponsor does not repay any debt, but reinvests the entire free cash flow (after paying the interest expense) into the business to grow the enterprise value (EV). At the end of Year 5, he sells the target for $1.55 billion and realizes 55% increase in EV. Since the debt claim represents a fixed claim on the business, the EV growth of $550 million accrues entirely to the equity value, thereby raising it to $850 million (= $300 million + $550 million). This scenario also yields an IRR of 23.2% and a cash return of 2.83x.
Thus, we see that both the scenarios have an impact in the returns of the sponsor’s equity investment. During the holding period, when the sponsor combines both debt repayment and EV growth together, the potential for higher returns increases tremendously. Usually, EV’s growth is attributed to the growth of EBITDA, which is achieved through organic growth, “bolt-on” acquisitions, stream-lining of operations, cost savings, etc.
Next article: LBO Economics and how leverage enhances returns